My last two posts have prompted a lively debate on the blog, and it is interesting to see how the debate parallels that which is taking place around the world. The G20 and G8 summits appear to be seeing the same divisions, with Obama on one side encouraging continuance of massive deficit spending, and the Canadians and many Europeans (e.g. Merkel, Cameron, Borroso) saying that the deficit spending has gone far enough (or perhaps already too far). This is from the Guardian:
Signs of deep rifts at the G8 and G20 summits in Toronto over how quickly governments should cut deficits added to financial market jitters today, with the Americans warning of the dangers of a double dip recession if all countries started to rein back spending at once.
The leading European economies, especially Germany, are putting a new emphasis on cutting back government spending, and there is a possibility that a G20 communique, due to be released on Sunday, will set out an indicative timetable of how far and fast countries should retrench spending.
David Cameron, making his first appearance at a world summit and packing in a frantic round of bilaterals to start building personal relations, was praised by the summits' host for his deficit slashing budget earlier this week.
The Canadian prime minister, Steve Harper, said that he welcomed Cameron's responsible and difficult decisions, saying the British prime minister's budget "had raised the very fiscal consolidation agenda that we are trying to steer the G20 towards".
Canada wants the G20 to endorse the idea that national deficits should be halved by 2013.
I highlight this, as the gap between the US approach to deficit spending and that of (for example) Germany can not be wider. There is a major fracture in the perspectives on economics between different countries.
The problem is that, there is no opportunity for either side to ever prove itself right, except through enacting their different approaches. However, in one respect, the Obama camp will be proven correct. That is, if there is a major move towards cutting of expenditure, a recession will almost certainly be the outcome. This will then give them an opportunity to say 'I told you so' and blame the problem on the cuts.
What we will never actually see, is what happens next if countries continue to rack up huge deficits, and the dangers that might flow from this enactment of policy. It will allow history to be rewritten to say that, had the spending continued, then the world would economy would have recovered, and all would have been well.
Set against this, I would point to the following article, which points to the underlying change in the world economy, a change which I have continually highlighted on this blog as inevitable, and the real driver behind the economic crisis:
Ten years ago, the world’s richest countries accounted for a significant majority of the globe’s economic activity. But the pendulum is swinging in the other direction, according to the Organization for Economic Cooperation and Development.
A new O.E.C.D. report finds that rich countries and poor countries now each contribute about an equal share of the global economy. And by 2030, developing countries will account for 57 percent of world G.D.P.
This has been at the heart of the thesis of this blog. The world has changed; the distribution of wealth in the world is changing, and it means that the developed world is no longer in the position where it might assume eternal wealth. We are now at the stage where month by month, we can see the reality of the change, and the attempts by many developed countries to turn back the reality failing. My argument, since before even starting to write this blog, has been that, for over a decade, we have misconstrued apparent economic growth for real economic growth. This is the view of the Economist:
Throughout the 1980s and 1990s a rise in debt levels accompanied what economists called the “great moderation”, when growth was steady and unemployment and inflation remained low. No longer did Western banks have to raise rates to halt consumer booms. By the early 2000s a vast international scheme of vendor financing had been created. China and the oil exporters amassed current-account surpluses and then lent the money back to the developed world so it could keep buying their goods.
Those who cautioned against rising debt levels were dismissed as doom-mongers; after all, asset prices were rising even faster, so balance-sheets looked healthy. And with the economy buoyant, debtors could afford to meet their interest payments without defaulting. In short, it paid to borrow and it paid to lend.
I was one of the doom-mongers when I first started writing about the economy. I was seen as (at best) a part of a mad fringe, but today we see the Economist saying exactly what I was saying long ago. However, even now, the problem remains that growth in debt is still mistaken for economic growth, and I despair of the mainstream ever 'getting' the distinction.
At this stage, it is worth offering a perspective on the scale and depth of the existing levels of debt in the developed world. The Economist has a special feature on indebtedness and produced the following chart () which ranks countries by debt sustainability (sorry about the size):
I strongly recommend taking a look at the interactive debt chart at the Economist here (sorry, can not be reproduced here). They follow their chart with this commentary:
The headlines are all about sovereign debt at the moment. But that is only part of the problem. Debt has risen across the economy, from consumers on credit cards, though industrial companies borrowing for expansion and financial companies using debt to buy risky assets.
The interactive graphic above [in the Economist article] shows the overall debt levels for a wide range of countries, based on data supplied by the McKinsey Global Institute. In theory there is no maximum level for debt relative to GDP, but Ireland and Iceland (not on this map) found the limit in practice when they hit eight-to-ten times GDP.
The massive debt accumulation does not tell the whole story. What we can see is that the debt is simply being used for consumption. It is not creating growth, but is leading to diminishing returns in growth - in other words, the real growth is taking place outside of the developed world, and the developed world is just living off that real growth. The chart below () from the Economist tells the story:
What this chart shows is the reality that has long been the subject of this blog, including in a recent post on post-Keynesianism. The money that is being borrowed and thrown into developed world economies is not producing a return. I made a comparison with China, where the government spending can make a return. It is very clear from the chart that borrowing more is not the answer (I know that the post-Keynesians will claim that their kind of borrowing and spending will be different....but see my post for why it will not).
However, it is quite possible for the US, for example, to continue to borrow from the new wealth creating countries and the oil states and appear to continue to be relatively prosperous. However, underneath such apparent prosperity is the reality that there are now the emerging economies that are being coming increasingly competitive, and taking a greater share of global wealth. Countries like China and India commenced with low end, low added value goods, but are rapidly rising up the value chain, and are starting to compete in the higher added value segments. The emerging economies will increasingly be meeting the developed world in the market for higher added value goods and services, and the developing world will
win market share.
This leads to the question of whether there will be a miracle of a return to the pre-crisis 'normality'. Can the developed world return to past levels of wealth, at the same time as new and aggressive entrants are entering into more segments of the world market. The Obama solution is built on the belief that, at some point in the future, growth in the economies of the developed world will return, and this will then allow for the existing economic structures to be maintained, and at the same time producing enough growth to repay debts accumulated now. After all, this has been what has taken place following previous recessions.
This view ignores the changes that are taking place in the apportionment of wealth, and also ignores internal factors that will further diminish potential for wealth creation, as well as the problem of structural entitlement programmes that will push up costs and diminish the ability to pay down debt. The first problem is one I have already discussed, the second and third are resultant from the basic demographic problem of ageing populations. In order for developed countries to simply stand still, there would need to be a significant productivity miracle, which will allow a shrinking workforce to support a growing population of retired people. The problem is that the developed world is not standing still, but is falling backwards.
If government borrowing and spending is removed from the equation, it is apparent that the economies of most developed countries are facing reversals in wealth as a result of the competition from the emerging economies. I think I might now be in a position where, when discussing the economic growth in the pre-crisis decade, few would propose that there was an underlying increase in the wealth, but rather an illusion of wealth created by debt. Since the crisis commenced, governments have replaced this debt with government debt, and this can only be sustained for so long. What this creates is a moment in time where existing economic structures might be retained, but no more than that.
In order for the changes in both the internal and external environments to be accommodated in the medium to long term, something must change. On the one hand, in response to the internal changes, there is the choice of using ever greater taxation to pay for the costs of a growing pool of retired people from a diminishing workforce. This would place a significant burden on the upcoming generation, whose potential for a 'good' lifestyle would be diminished through significantly higher taxation. Alternatively, the structure of the economy might be reformed through the reduction in entitlement programmes, or through allocation of funding now to support future entitlement programmes. At present, however, the assumption is that 'growth' will allow these entitlement programmes to proceed without any action now, or negative consequences on the upcoming generation.
Furthermore, when considering these future increases in costs from a shrinking tax base, they will also need to service the debts that are being accumulated in the present. As such, in addition to having to service the cost of a growing retired population, the shrunken tax base must also apportion more of their income in order to service debt. As such, there seems to be a huge assumption that either the upcoming generation are going to be hugely more productive than the previous generation and / or they will be willing to see much higher tax levels than the previous generation.
Furthermore, developing economies such as China are also major lenders into many of the developed economies, meaning that, as they continue to develop, they will have access to future resources and output of the developed world as they continue their growth, possibly allowing for an accelerated rate of growth. The upcoming generation must therefore achieve all of this as the emerging economies continue to grow their share of the economy, and move ever further up the value chain in competition with developed economies. I am now not alone in this point of view, and again from the Economist:
But in parts of the rich world such optimism may now be misplaced. With ageing populations and shrinking workforces, their economies may grow more slowly than they have done in the past. They may have borrowed from the future, using debt to enjoy a standard of living that is unsustainable. Greece provides a stark example. Standard & Poor’s, a rating agency, estimates that its GDP will not regain its 2008 level until 2017.
Rising government debt is a Ponzi scheme that requires an ever-growing population to assume the burden—unless some deus ex machina, such as a technological breakthrough, can boost growth. As Roland Nash, head of research at Renaissance Capital, an investment bank, puts it: “Can the West, with its regulated industry, uncompetitive labour and large government, afford its borrowing-funded living standards and increasingly expensive public sectors?”
Some of the commentators on the blog might note the use of the expression Ponzi scheme, as there has been a debate in the comments section of the blog on just this subject. The point is that there is no way in the world that the current economic structure of the developed world can be maintained. I have asked, and asked and asked where the real growth might come from to support developed world economies. It now seems that even the mainstream is coming to this question, and it is about time.
As such, when we look at the current debate, we can see two simple divisions. On the one side, there are a series of assumptions that there will be a growth miracle that will outstrip the results of demographic change in a world of increasing competition. On the other side is an assumption that something must be done now to accommodate the changes in the world. The consequence of the former, barring a miracle in productivity, is that the upcoming generation are going to be saddled with huge burdens, even assuming that the borrowing might be sustained into the near future.
On the other hand, the consequences of cutting now is to commence a process of realigning the economy to the actual wealth creating potential of the economy, and starting to face the problems that are rapidly accumulating. At its most basic, it is accepting that there needs to be a restructuring now, rather than imposing a huge (and probably in reality an unsustainable) burden on the future. I believe that, in the past, I commented on another Economist article that pointed out that, in the future, there will be a conflict of interest between the generations. The current debate about continuing of spending versus cutting now is in reality exactly this debate.
I have always realised that, if governments cut now, the consequence will be shrinking economies. I have never seen any way out, except to take this 'pain' sooner or later. However, I have always argued that sooner is better than later, as the accumulation of debt can only compound the existing problems. No doubt, if governments manage to really cut now (and that is still uncertain), then we will later see retrospective history claiming that the cuts were responsible for future problems that will indeed arise. However, such a perspective would be to ignore the real changes in the world economic structure, and these changes are not of the sort that can be wished away or ignored. The choices are simple, and the choices are 'who pays, and when?'
Notes: A long time ago I wrote some posts which proposed reforms which would try to maintain the essential underlying principles of several entitlement programmes in the UK (e.g. NHS, Education and Benefits). I wrote them from a basic principle; that we could not afford the current structures going forward. I sought to balance the underlying social and political demands with the coming shrinking of wealth. What we are now seeing is the discussion of necessary cuts, and I can only hope that these are undertaken in conjunction with the necessity for reform of the systems themselves.
What I would like to see is that, in the recognition of the difficulties ahead, that those in the future might enjoy something similar to what we (in the UK) have grown used to. In other words, the same underlying protections but pared down to achieve the original basic principles at the time of the establishment of the benefits. In addition to cuts, it is therefore necessary to reform, and I hope that this is the next phase in the transition. Unfortunately, since the time of writing the proposed reforms, governments have racked up ever greater debts, making it ever less possible to achieve this goal. This is why I have, since the start of this blog, argued against government borrowing.
As a further note to US readers, the examples of reform I give might seem to be puzzling in the context of the US experience. I am a firm believer that safety nets, education, and health care should be available to people, and you will see in the examples, methods that might allow for these to be achieved in the context of the UK's history and situation.